Lukomnik Wants to Make Capitalism Better–Tells Institutional Investors How

Jon Lukomnik is one of the pioneers of modern corporate governance. He co-founded the International Corporate Governance Network (ICGN) and GovernanceMetrics International (now part of MSCI), and served as interim chair of the Council of Institutional Investors’ executive committee. He serves as executive director of the IRRC Institute, whose research has been widely praised for objectively examining fundamental corporate governance and capital market issues. His recently published a new book, “What They Do With Your Money: How the Financial System Fails Us and How To Fix It,” co-authored with Stephen Davis and David Pitt-Watson, has been praised by notables such as Vanguard founder Jack Bogle, former UK Prime Minister Gordon Brown, and Yale Chief Investment Officer David Swensen.

Christopher P. Skroupa: Given your background, what motivated you to write this book? Was there a specific event, or was this an evolution of thought that came from your experiences?

Jon Lukomnik: The book was definitely the result of thought evolution. I realize that it takes some nerve to offer a book that takes on the whole financial system, let alone a plan on how to fix it. The easiest way to describe this evolution would be an anecdote: several years ago, I was sitting at the kitchen table with my two children, then aged 12 and 8, and they asked me what I do. My wife is a pediatrician, and kids know what pediatricians do. I had this weird job, with abstract concepts such as pension, investment, risk management, and corporate governance. So I tried to explain. My children sat with blank stares, somewhere in between boredom and pity. In absolute frustration I blurted out that I try to make capitalism safe for the world. That became a family catchphrase. Every morning when my wife left for work, we told her to “make the kids feel better,” and every morning when I left, she told me to “make capitalism better for the world.”

About 5 years ago, my colleagues and I were having a drink in London. It was post-financial crisis, and we were discussing everyone thought that everything was solved. But we felt the problem was more pervasive than the financial crisis, it was rather the business model of the finance sector. We suffer from a tyranny of errant expertise. We take a good idea and we use and abuse it to a reductio ad absurdum point, to where it isn’t a good idea any more. So diversification is a good idea, but when we rely on diversification of loans to the point where it leads to an absence of underwriting standards, that helps cause the global financial crisis.

My colleagues and I are devout capitalists. It isn’t possible to grow the economy, solve poverty and advance a sustainable future without capitalism and a well-functioning financial system. Yet we became frustrated with the false dichotomy presented, ‘either blow it up, the system doesn’t work,’ or ‘the system works, stop criticizing it.’ Our solution: constructively criticise to improve the financial system so as to serve the real economy better. That recognized both the societal usefulness of finance, as well as admitting that it is very sub-optimal in fulfilling that purpose. That conversation was the specific spark for the creation of my book.

Skroupa: How would you characterize the thesis of your book?

Lukomnik: The finance industry performs a myriad of essential functions, from safekeeping to facilitating payments to managing risk. But perhaps the most important is “intermediation.” This is a fancy word for what Lord Rothschild described, in a concise manner, as “taking money from Point A, where it is, and moving it to Point B, where it is needed.” Finance distributes capital to the necessary economic activity, however, we do not do this well. It costs two percent of capital to move money from Point A to Point B. Although that doesn’t sound like much, it has cost the same two percent for the last 130 years. Since that time, we have invented disruptive technologies, discovered new capabilities, landed on the moon, eradicated diseases and increased life expectancy. In almost every human endeavor, we have become more productive, except for in finance.

Another factor to consider is the drastic increase of intermediation within the real economy. The financial system intermediates about four times as much of our economic activity as it used to. The result is that today, about one out of every twelve dollars in the U.S. economy finds its way into the pockets of the financial sector. It’s no wonder that many Americans believe that Wall Streeters stand in a money stream and drink more than their share. Although there has been a major gain in intra-finance efficiencies, such as electronic transactions, credit cards and ATMs, a coincident growth in the number of financial intermediaries, along with some other factors, means the benefits have stayed within the financial sector. One study states that it requires sixteen agents to escort your savings from Point A to Point B, and they all get paid. The ever-increasing chain of agents has eaten up any potential of the micro-efficiencies actually being converted to productivity improvements that would benefit you and me and others in the wider economy.

Let me emphasize this: The people in finance are not corrupt, they are not evil, they are not ripping people off. Yes, there are individuals who do that, but that exists in every industry. But what is the cost of the exponential increase in the amount of intermediaries?

An additional issue is the misalignments to the needs of the real economy. There are 79,669 mutual funds in the world, I don’t know the right number, but I expect it’s something less than 79,669. They serve an important marketing purpose, which benefits the finance industry, but it also means that investing is more expensive for the rest of us than it could be, since economies of scale are not reached. In order to correct the current misalignment, we need to focus on finding efficiencies that accrue outwardly to benefit us all, not explosive political rhetoric that revolves around blowing up the system.

Fixing capitalism is a game worth playing, and it is a game worth winning. Imagine what society would look like if that two percent intermediation costs diminished to one percent. That one percent reduction in the cost of capital would have compounded over 130 years; imagine the improvement in our standard of living. Even just this year alone it would have made a difference. In the first quarter of this year, the U.S. economy grew at an annualized rate of about half a percent. Work out the math and cutting the intermediation cost by 1% would have increased the the growth rate of the entire economy .

So, the question we ask in What They Do With Your Money is simple: This industry is supposed to a service industry. How do we realign it to make it serve the real economy?